Polishing off Mackay's Querie

So when we left off, Paulson and Bernanke were trying to persuade banks to buy one another out so the government wouldn't have to take them over and fix them when they failed. Question 1: Why don't the banks want to buy eachother if they have so many incentives to do so? This question brings us to the "pushing on a string" phase of the boom-bust cycle. The Fed created the boom by feeding new money into credit markets, suppressing the interest rate. This caused an increase in the price of things which credit is used to buy, since there were more bidders with more money in their hands thanks to easy credit. The warping of the price structure caused malinvestment, warping the production structure. The Fed quit printing money when it realized that inflation was rampant, and the bust occurred. Now, nobody wants to lend, because everybody is going bankrupt. Every week, new banks go under. Would you lend a few million to a guy you knew could go under at any moment and stiff you for the bill? Especially if you were lending him money that you, in fact, borrowed? Of course not! So the credit maket "freezes up." The Fed tries pumping up the money supply with easy credit again (which, as we remember, caused the problem in the first place, the last time we had a crisis and needed easy money). But still nobody lends. This is "pushing on a string:" the Fed is pushing, the string is money. It pushes more money into the market to no avail, because a string is limp. It just goes slack and backs up. Right now, several large banks are sitting on enormous stockpiles of money, waiting for their rivals to go under. Second reason the banks don't want to lend: THEY ARE COMPETITORS! They've just spent the last ten years trying to drive one another under, and now that the competition is foundering on the edge of the abyss, they're supposed to throw them a lifeline? Ha! Third reason: IF a bank is to acquire another bank, how much better to acquire it after the Fed has picked up the tab for cleaning out all the bad debt? Why not buy the bank AFTER it fails? A tax break is just a tax break. It doesn't make the original purchase a good idea. By assuming the bad debt buying the bank now, the buyer accepts 100% of the loss and writes off 40% in tax. Net loss of 60%. If it buys the bank after the bad debt is gone, it has no loss at all, but pays 40% tax on its gains. Net gain of 60%. Which would you choose? Bottom line: the wealth has already been destroyed. The houses were lousy investments in the first place. The physical reality of the world has not changed, and cannot be changed by accounting chicanery. Right now, people are fighting over who has to pick up the tab. The Fed wants private markets to do it. The private market wants the Fed to do it. So we come full circle: it really was a redistribution question. Maybe I wasn't wasting my time. As I see it, the rule change probably won't matter that much. The bill has to be paid either way. My guesstimate is that this will be a $1-2 trillion fiasco. That's a $1-2 trillion dollar bill that has to be paid by somebody. The S&L crisis of the '80's was a $1/2 trillion affair. The "tax break" means Uncle Sam forgoes tax revenue but gets to avoid footing the bill for the actual "fixing" of the banks. Uncle Sam saves 60% of the total cost of the bill for any particular bank this way, the bank which does the buying assuming the balance. He's trying to save taxpayer money. He also gets to avoid the bad political publicity of having to seize a bank. He pays 40%, the banks pay 60%. But the banks have to do the buying out. If the banks don't do a buyout, they pay tax on their gains. But Uncle Sam has to pay to fix the failed banks. Uncle Sam pays 60%, the banks pay 40% in taxes. The banks won't agree to completely buyout all their failed rivals, that's only logical. You don't pay a bill you don't have to pay. The only banks they will buy will be the ones they wanted to buy anyway. This tax rule will alter decisions on the margin, increasing the value of a marginally decent looking buy for a good bank. But this will be a very small number, as indicated by the math I talked about before. Mostly, banks would rather Uncle Sam pick up the tab. It will only slightly increase the number of buyouts. On the other hand, it will be a "windfall" for the banks that would have been bought anyway, such as the buyouts that had already occurred before the rule change was made. This is probably what people are griping about. At any rate, I think that's the best I can do with this question. I personally don't think the rule change makes much difference for the present situation, but in the long run, if it stays in effect, it may influence decisions down the road. It should have a general effect of causing increased bank consolidation beyond what would be rational in a free market. I hope it is nullified before too long. I don't like tax law being used to alter rational decision making. It usually leads to bad decisions.